Flaws in the federal set-up

Economists Wallack and Srinivasan (Federation and Economic Reform – International Perspective) have studied countries representing a varied cross section of six developing and two industrialized federal nations.

Their incomes per capita varied from US$25,000 (Purchasing Power Parity) in Australia and Canada to US$758 in Nigeria. They have provided some conventional wisdom and universal conclusions which could be used to do a benefit-cost analysis of the current federalism proposal of this administration.

Federalist literature has listed several advantages of federalism both political and fiscal citing the benefits of developing taxation and expenditure authority across lower levels of government citing that local government are assumed to have an information advantage in identifying local needs. Decentralization allows, it is said, for more leeway in the provisions of public goods to satisfy local preferences. Mobility of factors of production, it is assumed, also ensures the efficient matching of expectations of constituents with the jurisdictions that provide public good thereby optimizing welfare through the efficient distribution of the above.

Today we have a proposal for a federal state now being discussed in Congress to replace our unitary one. The federation-to-be as submitted will comprise of 11 federal states that would be created out of the existing administrative regions, so that the identities of the proposed states would already be known by the people.
The breakdown is as follows:

•Mindanao: 3 states (Northern Mindanao, which may be subdivided into Northwestern and Northeastern Mindanao; Southern Mindanao, Bangsamoro).

The advantages of developing taxation and expenditure authority across levels of government is based on the assumptions that local government are supposed to have an information advantage in identifying local needs. Additionally, decentralization is touted to allow it is said for more variety in the provision of public goods so that local preferences can be satisfied. Mobility of factors of production it is assumed also ensures efficient matching of citizens with jurisdictions that provide the infrastructure and social service they desire.

The assumptions are that the states are:

• Able and benevolent social planners.

• Considerate to the reality of international integration and not only focused on closed economies.

• Able to produce a socio-economic equilibrium in which people and state governments are optimally matched.

• That state government governors are better social planners and not swayed by prospects of reelection and the “perks” of office.

• Have the capacity and power to enforce the policies they deem desirable.

• Certain that central governments cannot alter local policies.

• Have citizens yhay exercise tighter control over local officials.

Advantages of Federalism

It is further argued that federalism will:

• Encourage local initiatives because the entire nation is not straitjacketed by uniform policy to which every state must conform. State and local governments may be better suited to deal with specific state and local problems.

• Permit pursuits of local goals because it permits citizens to decide many things at the state and local levels of government and avoid battling over single national policies to be applied uniformly throughout the land.

• Allow for power redistribution because federalism disperses power. Moreover the widespread distribution of power is generally regarded as a protection against tyranny.

• Increase political participants because federalism allows more people to run for and hold political office.

• Improve efficiency. While it may be thought that some dozen state governments may produce inefficiencies, governing an entire nation from imperial Manila is perceived to be much worse.

• Will allow for greater citizen mobility which will provide the residents’ ability to move to other jurisdiction.
• Will promote competition among states which can lead to faster growth.

• Finally, will provide a greater system of checks and balances to national governance power.

Disadvantages of Federalism

The downsides of federalism as cited by its critics are the following:

• Federal states are less accountable for a country’s macroeconomic instability. State governments may demand extensive subsides in exchange for continued support for the federate government.

• Negative macroeconomic effects of federalism stem in large part from central governments’ inability to restrict opportunistic state government behaviour.

• The foundation of wide-ranging state borrowing autonomy and increasing transfer-independence is increasingly common, especially as countries decentralize expenditures by ramping transfer rather than building up the local tax base. Develop culture of dependency.

• It limits redistribution in the sense that progressive taxation and generous welfare benefits are likely to drive the well-off away and attract the poor, eroding for redistribution.

• Federalism tends to overlook externalities because competition for business and citizens may lead state governments to settings inefficient lower business and income taxes leading to regressive taxation.

• Federalism protects special interest groups allowing them to protect their privileges.

• Uneven distribution of benefit can result from federalism because benefits and costs of government are spread unevenly e.g. one state spend more than twice as much per capita as other states on education.

• Federalism can also create disadvantages in poorer states and communities which can only provide lower levels of education, health, and welfare services; polices protections; and environment protection than wealthier states and communities.

• Finally federalism it is feared may obstruct action on national issues (in the case of the states in the United States, states obstructed efforts of the Federal states to remove racial discrimination etc.)

Fiscal Flaws

The most compelling criticism of federalism is the charge that local governments may overspend on capital when capital transfers are easier to obtain than funding for current expenditure or vice versa, for example.
The critics have pointed out that in the case of grants, equalisation funds and federal fund transfers to subsidize poorer jurisdictions local politicians overspend from the pot of national resources creating an attitude of mendicancy

Indeed local government over-expenditure can contribute significantly to the country’s overall debt burden. Local control over regional banks can also drain the national financial sector, as the central government may face the choice of bailing out regional banks or suffering mote widespread financial repercussions that spell over state borders.

They might overestimate the cost of providing primary education, for example, to attract more funds from the central government.

State government may collect too little taxes owing to a race to the bottom to compete for mobile factors or impose too high levies when politicians at each level government act as revenue-maximizing “Leviathans”.

The US record

In the US, 10 reasons have been advanced as to why the federal aid system doesn’t make any economic or practical sense and ought to be downsized or eliminated.

• Unsustainable deficit financing.

–By moving the funding of state activities up to the federal level, the aid system has titled American government toward unsustainable deficit financing.

• Grants spur wasteful spending.

–The basic incentive structure of aid programs encourages overspending by federal and state policymakers. One reason is that policymakers at both levels can claim credit for spending on a program, while relying on the other of government to collect part of the tax bill.

• Aid allocation doesn’t match any consistent idea of need.

–“Federal grant-in-aid programs have never reflected any consistent or coherent interpretation of national needs.”

• Grants reduce state policy diversity.

–Federal grants reduce state diversity and innovation because they come with one-size-fits-all mandates.

• Grants regulations breed bureaucracy.

–Federal taxpayers pay the direct costs of the grants, but taxpayers at all levels of government are burdened by the costly bureaucracy needed to support the system.

• Grants cause policymaking overload.

–One consequence of the large aid system is that the time spent federal politicians on state and local issues takes away from their focus on truly national issues.

• Grants make government responsibilities unclear.

–As the saying goes, when every government is responsible for an activity, no government is responsible.

• Common problems are not necessarily national priorities.

–In brief the federal aid system is a roundabout way to fund state and local activities that serves no important economic or practical purpose. The system has many widely-recognized failings, but a web of special interest groups block reforms.

• Skewed distribution

–Progressive taxation and generous welfare benefits are likely to drive the well-off away and attract the poor, eroding the scope for retribution. Country case studies however will, this kind of centralized redistribution may no longer be as ideal when central government redistribute to ensure longer tenure in office of other non-welfare-related goals.

• Unhealthy competition

–Competition for business and citizens may lead state government to set inefficient lower business and income taxes, for example. Lower level governments’ quest to tax less mobile bases is also likely to lead to regressive taxation since the poor tend to be among the least mobile.

Fiscal indiscipline

The common pool paradigm often produces moral hazards causing politicians to overspend from the pot of national resources (including both taxes and captive savings in the financial system) is also pervasive.

• Contribute to debt burdens

–Local governments over-expenditure can contribute significantly to the country’s overall debt burden. Local control over regional banks can also drain the national financial sector, as the central government may face the limited choice of bailing out regional banks or suffering more widespread financial repercussions that spill over state borders.

• Lack of transparency

–States sometime conceal information from the central governments to gain more resources to spend on attracting votes in elections or rewarding key supporters. They might overestimate the costs of providing primary education, for example, to attract more funds from the central government.

• Corrupt officials

–The goal of increased local self-sufficiency can be extremely difficult in poor countries with weak or corrupt local government institutions and high levels of inequality.

• Weak central government

–A weak, fragmented central government or even those beholden to state governments make it difficult to censure them or change the basic fiscal and political institutions that create bad policies.

Optimal tax structures – Unitary vs. Federal

Unitary forms of government are likely to choose optimal tax structures since policy will be driven by the wishes of state representatives. Stronger nationally elected politicians (such as the executive), and constitutional restrictions on the kinds of taxes that state governments can have will lead to more efficient outcomes.
Central governments will distribute funds differently than in a unitary state where they could just reach directly to voters.

In sum can we expect federal states to be moving toward efficient equilibrium? Does it have the ability to respond to changing economic and political environments, including greater integration? It has been shown that Federal state can get stuck in inefficient arrangements, for example, when mistrust is generated by underlying ethnic or socioeconomic heterogeneity. Federal bargains will be more difficult to change when provision are written into constitutions or otherwise require supermajorities or unanimity for revisions.

Because of disparities in the level of development of the proposed federal estates an equalization fund has been proposed as a leveling mechanism. In the US this is known as federal grants in aid.

The experience in that country has been unsatisfactory causing a move to cancel this or substitute another mechanism.

It has been shown that most federal politicians cannot be trusted to pursue broad, national goals, but are consumed by the competitive scramble to secure subsidies for their states. At the same time, federal aid stimulates overspending by state government and creates a web of top-down rules that destroy state innovation.